On Globalization and the Growth of Governments

This paper investigates the relationship between trade openness and the size of government, both theoretically and empirically. We show that openness can increase the size of governments through two channels: (1) a terms of trade externality, whereby trade lowers the domestic cost of taxation and (2) the demand for insurance, whereby trade raises risk and public transfers. We provide a uni\u85ed framework for studying and testing these two mechanisms. First, we show how their relative strength depends on a key parameter, the elasticity of substitution between domestic and foreign goods. Second, while the terms of trade externality leads to ine ¢ ciently large governments, the increase in public spending due to the demand for insurance is optimal. We show that large volumes of trade may result in welfare losses if the terms of trade externality is strong enough while small volumes of trade are always bene\u85cial. Third, we provide new evidence on the positive association between openness and the size of government and test whether it is consistent with the terms of trade externality or the demand for insurance. Our \u85ndings suggest that the positive relationship is remarkably robus